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In an insolvency, the three heads of set-off (contractual, legal and equitable) each represent a powerful means of effectively jumping the queue and circumventing the ordinary priority scheme between a company's secured and unsecured creditors.

In a recent novel decision, Re Strellmax1, the Ontario Superior Court of Justice [Commercial List] examined the extent to which an unsecured creditor can use the doctrine of legal set-off for a debt owed to it by a company in receivership against property (albeit in the form of cash) belonging to the company in receivership and in possession of the creditor.

The creditor in this case, Accord Financial Ltd. ("Accord"), had a multi-faceted relationship with the company in receivership, Strellmax Ltd. ("Strellmax"), which prior to the appointment of the Receiver operated a retail and wholesale men's clothing business in Canada.

In the course of this relationship, in addition to issuing a letter of credit on behalf of Strellmax, to and in favour of Strellmax's principal supplier (the "Letter of Credit"), Accord had entered into a collections agreement with Strellmax (the "Collections Agreement") pursuant to which, in exchange for a commission, Accord collected accounts receivable owing to Strellmax from its retail and wholesale customers (the "Controlled Funds").

Under the Collections Agreement, Accord was required, generally speaking, to remit to Strellmax on a daily basis the Controlled Funds it had collected.

Subsequent to the appointment of the Receiver, the principal supplier of Strellmax (who had at this point taken an assignment of Strellmax's senior secured debt) demanded payment in full on the Letter of Credit from Accord.

Notwithstanding that it refused to honour this demand on the Letter of Credit, other than through a token payment of $1 (designed to effectively preserve its rights), Accord sought to set-off its potential full liability under the Letter of Credit against the Controlled Funds then in its possession. Absent the ability to set-off against the Controlled Funds, it was apparent in the proceedings that Accord would not be able to recover any of this amount in its capacity as an unsecured creditor.

In a detailed and extensive decision the Court ultimately dismissed Accord's claim for set-off.

In determining whether Accord had a claim to legal set-off, the Court examined whether Accord's obligation to remit the Controlled Funds to Strellmax qualified as a "liquidated debt" sufficient for the purposes of the first branch of the test for legal set-off. The Court, relying on previous decisions of the Supreme Court of Ontario (Appellate Division) (as it was then) in Clarkson2 and the British Columbia Supreme Court in Nesmont3, found that Accord's obligation to deliver the Controlled Funds to Strellmax under the Collections Agreement was an obligation to deliver property and not an obligation to pay a "debt". In each of these underlying decisions, a distinction was drawn between a debtor-creditor relationship and the situation where a party is holding property as a custodian, agent, bailee or trustee for another.

Examining the facts in this case, the Court found that Accord's attempt to characterize its obligation to return the Controlled Funds as a "debt" was inconsistent with a prior written acknowledgment Accord had delivered to Strellmax's senior secured lender that had stated that title to the Controlled Funds would at all times remain with Strellmax. Accord, as a result, was unable to use legal set-off as a means to retain the Controlled Funds.

In light of the Court's decision in Re Strellmax, it appears that in the right circumstances one may be able to challenge a claim for legal set-off by looking at the actual underlying relationship between the parties. If the relationship is truly one of custodianship, agency, bailment or trust, legal set-off may not be available.

For lenders providing credit facilities to borrowers that retain third party collection or cash transportation agencies, the decision also stands as a powerful reminder of the value of obtaining an acknowledgment or no interest letter from these third parties, as a backstop against any future dispute over entitlement to funds in their possession.

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